Articles Posted inPost-Production Costs

Our firm hosted its 4th land and mineral owner seminar last Friday, and I spoke on deductability of post-production costs from lease royalties in light of the Texas Supreme Court’s decision last year in Chesapeake v. Hyder. My paper on post-production costs may be viewed here: Post-Production Costs after Hyder

This is the first case to follow Chesapeake v. Hyder, the Texas Supreme Court’s most recent case addressing deductability of post-production costs from royalty payments.

Like Hyder, the instrument construed in Burlington v. Texas Crude involved an overriding royalty interest. The language construed by the court in Burlington provided that the overriding royalty would be paid on the “amount realized” by the lessee, and said that the overriding royalty would be paid “free and clear of all development, operating, production and other costs.” The Court of Appeals concluded that the Supreme Court’s ruling in Hyder controlled its construction of the language and that Burlington had to pay the overriding royalty without deducting post-production costs.

Chesapeake has sent royalty owners letters saying it has overpaid them by failing to deduct post-production costs and demanding reimbursement. Post-production cost deductions are exceeding revenues on Chesapeake’s royalty checks, resulting in a “negative royalty.” The Commissioners of Bradford County, in the heart of the Marcellus play, have commissioned a video advocating for passage of a bill to require companies to pay a minimum royalty of 1/8th, regardless of the amount of post-production costs. Pennsylvania has a Guaranteed Minimum Royalty Act that requires all leases to contain no less than 1/8th royalty. But the state’s Supreme Court ruled in 2010 that the Act didn’t prevent companies from deducting post-production costs.

Chesapeake has the same problem in Pennsylvania that it had in the Barnett Shale play. In both cases, it made contracts between its affiliated companies to charge high fees for gathering and marketing its gas and then sold those affiliated gathering companies for a substantial premium. It’s now stuck with those very unfavorable post-production costs, and is charging those costs back to the royalty owners.

Chesapeake Energy announced last week that it is selling (giving away?) all of its interest in the Barnett Shale to Saddle Barnett Resources, LLC, a company backed by First Reserve. First Reserve is a global private equity investment firm. The Barnett Shale is the birthplace of the shale revolution in the U.S., and the origin of Chesapeake’s meteoric rise as the premier shale gas producer in the country. A key part of the transaction is Chesapeake’s renegotiation of its gathering agreements with Williams Partners. According to Chesapeake’s press release, renegotiation of the Williams agreements will save Chesapeake $1.9 billion in future midstream and downstream costs. Chesapeake is paying Williams $334 million to get out of the contract, and Saddle Resources is “expected to pay an additional sum.”

The sale covers 215,000 net acres and 2,800 wells producing 65,000 boe per day, 96% of which is natural gas. The deal is projected to save Chesapeake $200 to $300 million annually.

It is difficult to know exactly what this transaction entails without knowing more details, but it looks like Chesapeake is in effect transferring its Barnett leases to Saddle Resources for no consideration, and is in addition paying Williams Partners $334 million to get out of the onerous terms of the gathering/transportation agreement. It also looks like Chesapeake has been operating its Barnett leases at a loss, largely because of the Williams gathering/transportation agreement.

Last week the Texas Supreme Court denied Chesapeake’s motion for rehearing in Chesapeake v. Hyder. The court originally affirmed the lower courts’ opinions in favor of the Hyders, with four justices dissenting. On rehearing, the court’s alignment did not change, but Justice Hecht issued a new opinion for the majority, and Justice Brown issued a new dissenting opinion, joined by Justices Willett, Guzman and Lehrmann.

These new opinions end a long fight between Chesapeake and the Hyders over the deductability of post-production costs from their gas royalties in the Barnett Shale area. Although the leases contain strong language against deduction of post-production costs, Chesapeake argued that, under the precedent of the prior Supreme Court decision of Heritage Resources v. NationsBank, 929 S.W.2d 118 (Tex. 1996), it could deduct post-production costs. Chesapeake lost in the trial court and the court of appeals. The Supreme Court granted Chesapeake’s petition for review but affirmed the decisions below, split 5 to 4. With the denial of Chesapeake’s motion for rehearing, that decision is now final.

The Hyders’ lease allows Chesapeake to drill horizontal wells from surface locations on the Hyders’ property which produce from adjacent lands — in other words, to use the Hyders’ land to produce oil and gas from adjacent properties. As consideration for that right, the Hyder lease grants the Hyders a royalty interest in production from those wells — an “overriding royalty,” carved out of Chesapeake’s working interest in the leases covering those adjacent lands. The Hyder lease provides that the Hyders are granted “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent of gross production obtained” from such wells. The argument was over the meaning of that language. Chesapeake argued that “cost-free” meant free of production costs; the Hyders argued that “cost-free” means fee of production and post-production costs.

Lawyers have filed a new class action against Chesapeake in Pennsylvania. The suit is against Chesapeake Energy and Chesapeake Marketing, filed in the US District Court for the Middle District of Pennsylvania. The plaintiffs also filed a demand for arbitration with the American Arbitration Association against Chesapeake Appalachia, LLC. According to the arbitration demand, title to Chesapeake’s leases in Pennsylvania is held by Chesapeake Appalachia, and many of those leases contain arbitration clauses requiring the lessor to arbitrate its claims. The complainants make the arbitration demand on behalf of all royalty owners in Pennsylvania who have leases with arbitration clauses.

The suit and the arbitration demand make similar claims, that Chesapeake through its affiliated companies “(1) paid the royalties on less than the revenue paid by the buyer, (2) paid no royalty on the proceeds of derivative contracts, (3) deducted costs incurred after [Chesapeake] no longer held title to the gas, (4) deducted gathering costs that were inflated through collusion and self-dealing with Access Midstream Partners, L.P., (5) deducted transportation costs that were fraudulent in their amounts, (6) deducted marketing fees that were never incurred, and (7) calculated the royalties on some of the gas without determining either the price paid or the costs deducted.”

Three amicus briefs have been filed in support of the Hyders, opposing Chesapeake’s motion for rehearing of the Texas Supreme Court’s decision in Chesapeake v. Hyder.

An amicus brief was filed by the City of Fort Worth and others who have filed suits against Chesapeake and Total to recover additional royalties on production in the Barnett Shale area: City of Fort Worth Amicus Brief

An amicus brief was filed by a group of royalty owners represented by Dan McDonald, a Fort Worth attorney who has filed 430 separate suits against Chesapeake, representing more than 20,900 royalty owners in Johnson and Tarrant Counties: Barnett Shale Royalty Owners Amicus Brief

The Texas Supreme Court asked the Hyders to respond to Chesapeake’s motion for rehearing in Chesapeake v. Hyder, after the court’s recent 5-4 decision in favor of the Hyders. Several amicus briefs (“friend of the court” briefs by entities not parties to the case) were filed in support of Chesapeake’s motion for rehearing. Exploration companies are clearly unhappy with language in Chief Justice Hecht’s majority opinion and asking the court to modify its language. The amicus briefs made the San Antonio Business Journal’s “Eagle Ford Shale Insight” feature.

I’ve written about this case before, and our firm filed an amicus brief in the case before the court issued its opinions, on behalf of Texas Land & Mineral Owners’ Association and the National Association of Royalty Owners-Texas.

So far, on rehearing, the following parties have joined in amicus briefs criticizing the court’s majority opinion:

A federal judge in Dallas has ruled that Chesapeake cannot deduct post-production costs on the Plaintiffs’ leases covering lands in Tarrant and Johnson Counties, in the Barnett shale. The order can be viewed here: Winscott – Order on MSJs

The case is Trinity Valley School, et al. vs. Chesapeake Operating, Inc., et al., No. 3:13-CV-08082-K, in the US District Court for the Northern District of Texas, Judge Ed Winscott presiding. The order, although a partial summary judgment, appears to resolve Chesapeake’s claim of right to deduct post-production costs. Plaintiffs include Ed Bass, the Harris Methodist Southwest Hospital and Texas Health Presbyterian Hospital Dallas. The language construed in the leases varies, but all of the leases contain language dealing with sales to an affiliate.

As I have discussed before, Chesapeake sells its gas at the well to its affiliate Chesapeake Energy Marketing (CEMI). The price on which Chesapeake pays royalties is based on the weighted average price CEMI receives for the gas less gathering and transportation costs incurred by CEMI and a CEMI marketing fee.

Dan McDonald, a Fort Worth attorney, has filed some 250 cases against Chesapeake contending that it is underpaying its royalty owners. Companies affiliated with former House of Representatives Speaker Tom Craddick have now been added to McDonald’s client list. So many cases have been filed against it in Texas that Chesapeake asked the cases to be granted multidistrict litigation status, so that one judge could control pretrial discovery and motions and settings. Two judges have been appointed for that purpose, one for McDonald’s cases and another for cases brought by other attorneys. Chesapeake is settling cases as fast as it can.

Most of the claims against Chesapeake arise from its structure for selling gas. Chesapeake sells its gas at the wellhead to its wholly owned subsidiary Chesapeake Energy Marketing. Chesapeake Energy Marketing arranges for the gathering of the gas and delivery to central sales points, and pays Chesapeake for the gas based on a weighted average price of all sales at those central gathering points, less costs of compression, gathering, treating and transportation, and less a “marketing fee” charged by Chesapeake Energy Marketing. The costs incurred between the wellhead and the point of delivery to the purchaser were formerly incurred by another Chesapeake affiliate, Access Midstream. Chesapeake spun off its gathering systems into a separate company a few years ago, and as part of that deal it guaranteed a minimum rate of return on those gathering systems to the new spin-off company, thereby receiving a premium price in the market for the new company’s shares. Chesapeake pays royalties based on the new price it receives from Chesapeake Energy Marketing, after deduction of post-production costs and marketing fees. McDonald says that these “costs” are “sham sales” and “fraudulent transactions.”

This Blog/Web Site is made available for educational purposes only as well as to give general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand that there is no attorney client relationship between you and the publisher. The Blog/Web Site should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.